An Enron moment –– def. when an accounting ploy to offload toxic assets to an unconsolidated LLC backfires.

The Bancorp’s Continuing Problems

The Bancorp (NASDAQ: TBBK) is a publicly-held Philadelphia regional bank with a diversified loan portfolio, but also known for being one of largest issuers of reloadable prepaid debit and gift cards in the country.

We have written a number of papers since early 2015 detailing its “continuing problems with a discontinued commercial loan operation.” There have been two basic points we have tried to make:

“The independent investor in Walnut Street, the securitization into which the Bank sold certain loans when it discontinued its Philadelphia commercial loan operations, has taken actions which may result in litigation.

Specifically, counsel for the independent investor has requested that the Note Administrator hold monthly distribution payments in escrow until the independent investor’s alternative interpretation of the order of payments, as compared to the interpretation of the Bank and the Note Administrator, is resolved.

Based on the independent investor’s request, the Note Administrator withheld the September 2017 payment to the independent investor and the Bank and indicated that it would continue to do so until this issue was resolved.”

Based on names in a copy of the Purchase Agreement between The Bancorp and the LLC, we believe that the sale was between two friendly parties rather than an arm’s-length transaction.

The so-called “independent investor” in the Walnut Street LLC was Angelo, Gordon & Co (AG & Co.) out of New York City. According to its website, AG & Co. is a large $26 Billion manager of “alternative investments” including commercial real estate mortgage-backed securities (CDOs).

Legally speaking, AG & Co. is an unrelated, third party to The Bancorp and its Chairman Daniel G. Cohen. But, AG & Co. is listed as a “banner investor” of a firm that merged into Cohen’s latest concoction — a “blank check” IPO called Fintech Acquisition Corp, which we have written about in our paper Fintech Acquisition “Blank Check” IPO: Buzzy Name Fuzzy Aim.

The LLC’s “Designated Manager” was Kenneth L. Tepper, head of Kildare Financial Group, an independent contractor that has been used by the FDIC to sort out bankruptcy messes. The initial address for the LLC was c/o PLANcorp in Gladwyne, PA, another Tepper controlled company.

It turns out Tepper has close ties to The Bancorp. According to a Bloomberg bio, Tepper has served as Managing Director of Financial Institutions Group at Cohen & Co, a firm founded by the family of Chairman Daniel G. Cohen. In short, Kenneth L. Tepper was a front for The Bancorp when it set up the LLC in 2014.

Finally, we just want to mention that the very name for the LLC — Walnut Street 2014-1 Issuer, LLC. — marks the LLC as part of The Bancorp “family”, not a true partnership.

The Bancorp’s founder, Betsy Z. Cohen, the mother of Bancorp Chairman Daniel G. Cohen, was instrumental reviving the Walnut Street area of downtown Philadelphia in the 1970s by making risky loans to startup restaurants in the area. It is ironic that the same Walnut Street name that was associated with a civic-minded banker/mother in the 1970’s is now associated with a rule-bending banker/son now.

In sum, the dispute that The Bancorp quietly buried in Note 13 of its 3Q17 10-Q is about a deal between friends gone bad.

The Toxicity of the Bancorp’s Unconsolidated LLC

On October 31, 2014, The Bancorp announced that it was discontinuing its $1.2 Billion commercial lending operation. It set aside this portfolio on its balance sheet, claimed it was marked-to-market, and that the bank was actively seeking buyers. Since that announcement, the bank has had considerable trouble selling off the most troubled segments to third-parties.

On the next to the last trading day of 2014 when most of us are making New Year’s plans, The Bancorp issued a terse 8-K saying it had made the first sale to a partnership called Walnut Street 2014-1 Issuer, LLC.

What caught our eye initially in early 2015 was NOT the financing structure. That came out nine months later. What caught our eye initially was the stark contrast in markdown between the sale portion to the LLC and the remaining portion of the discontinued loan portfolio.

In February, 2017, the Bancorp provided an update (see above) to the loan portfolio held by its unconsolidated LLC in a note accompanying the release of its 4Q16 financials.

Based on that information we calculated a 40.6% AVERAGE markdown of the LLC portfolio despite 79% of loan principals were classified “performing.”

What a joke! The incongruity of these two statistics confirms the meaninglessness of “performing” as a sign of loan quality when a loan operation engages in “extend and pretend.”

Obviously, a lot of the so-called “performing” loans had been modified to interest only with a balloon payment after a number of years. And the non-performing loans probably involve skipped balloon payments rather than skipped flat payments according to a normal amortization schedule.

Nine months after the Bancorp finally issued its 2014 10-K (another bank debacle detailed by us elsewhere), the bank revealed that it did not consolidate this LLC into its balance sheet despite the fact that the overwhelming proportion of the LLC’s financing came from the sale of notes back to The Bancorp itself. The table below is our presentation of the variable interests in the LLC as detailed in Note H of the bank’s 10-Ks:

“(1) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance; and

(2) through its interests in the VIE, the obligation to absorb losses or the right to receive benefits from the VIE that could potentially be significant to the VIE.”

The fact that bank waited until the day before New Year’s to disclose this sale in a terse 8-K plus the fact that the structure of the deal was so convoluted, giving its partner 51% of the voting stock despite practically no “skin in the game”,suggested to us right from beginning that The Bancorp was testing the limits of Post-Enron GAAP.

In Note H of its 10-K, the bank had nothing to say about who had the most power to make decisions that affected the performance of the LLC. It just ended the note abruptly with this conclusion: “The company is not the primary beneficiary, as it does not have the controlling financial interest in WS 2014 (the LLC) and therefore does not consolidate.”

We have written an accounting paper, The Bancorp: A Test for Post-Enron GAAP, presenting more evidence in support of our believe that it is The Bancorp that controls the LLC and not it’s so-called independent partner Angelo, Gordon & Co with 51% of the equity.

In previous papers, we suggested that the bank’s independent auditor, Grant Thornton LLP, take a harder look at the Bank’s election not to consolidate. We renew that suggestion here. Oh…wait…

“He will work with the Audit Committee and Executive Management to assess, direct and maintain The Bancorp’s audit management plan and oversee internal audits, risk assessments and audit finding remediation”.

It also says that

“Most recently, he was Director, National Business Advisory Services, for Grant Thornton LLP”

The Bancorp’s “Enron Moment”

An Enron moment –– def. when an accounting ploy to offload toxic assets to an unconsolidated LLC backfires.

Clearly, the so-called independent partner Angelo, Gordon & Co. (AG&Co) is not happy with the performance of the LLC and wants more cash out now.

AG&Co is a savvy player in the distressed commercial real estate market. They must have had a plan to get enough cash out early to more than cover their $16 Million investment before the flood of defaults inevitably arrives.

The LLC is clearly unprofitable. Portfolio interest income (cash and accrued) is not enough to offset the $24 Million (non-cash) expense of additional markdowns plus the $6.6 Million in notes payable interest (cash) to The Bancorp and considerable legal expenses (cash).

Even without precise numbers to calculate profitability, the LLC’s is clearly insolvent (assets – liabilities < 0) with $24 Million in additional markdowns since inception wiping out the $16 Million in initial equity.

The LLC is overall cash flow positive only because of the $24 Million in paydowns.

In our opinion, AG&Co has the edge in this dispute as they have 51% of the voting stock. Even though there might have been documents created at the LLC’s inception that support the Bancorp’s position as to the distribution of cash to partners, it would seem to us that AG&Co has enough votes to rewrite these instructions in their favor.

The moral of this story is that you cannot both control and not control an unconsolidated LLC with a convoluted ownership structure.

Based on details presented below, we believe that The Bancorp is not in compliance with Post-Enron GAAP (specifically FASB 46R amended by SFAS 167, also know today as FASB ASC Topic 810-10)

Introduction

Generally accepted accounting principles (GAAP) relating to consolidation of subsidiaries have changed dramatically in response to the Enron scandal of the late 90s. Pre-Enron, GAAP for consolidation was specified in ARB No. 51. It said to the effect that an enterprise must consolidate all subsidiaries in which it had a controlling financial interest as defined quantitatively by a majority voting interest.

Between 1998 and 2001, Enron’s CFO Jeffrey Fastow exploited that rule mercilessly by creating a number of minority equity interest LLCs to buy Enron oil and gas assets that had not been fully marked down to market. Enron did not consolidate these LLCs citing ARB No. 51.

Nevermind if Enron had total power to direct the activity of the LLC with Fastow himself as managing director paid millions of dollars a year. Nevermind if Enron had a majority financial interest when debt was considered due to loans from banks secretly secured by Enron common stock.

Instead, FASB said that an enterprise must consolidate a variable interest entity (VIE) — variable shares of equity and debt — when it had a controlling financial interest as defined quantitatively by the obligation to absorb the major share of losses or the right to receive the major share of benefits.

In 2009, FASB amended FIN 46R to take into account the valid criticism from lenders to VIEs who had to consolidate because they had a majority financial interest but absolute no power to direct the activities that affected the financials.

FASB 46R – amended by SFAS 167 (today called FASB ASC Topic 810-10) added a qualitative stipulation that a corporation must consolidate a VIE if it had most of the power to direct the activities as well as a majority interest in the resulting financial gains and losses.

Majority financial interest can be determined quantitatively and has been relatively easy to evaluate for compliance. But, as PwC lamented in a bulletin, the qualitative question of who has the most decision-making power “will require considerable judgment.”

The purpose of this paper is to review a late 2014 non-consolidation decision of The Bancorp (NASDAQ:TBBK), a Philadelphia area bank regulated both by the FDIC and the Federal Reserve with a diversified loan portfolio, but also known for being one of largest issuers of reloadable prepaid debit and gift cards in the country.

The non-consolidation decision has been reviewed and approved by its outside auditor Grant Thornton LLP.

We are not sure if the FDIC or Federal Reserve has reviewed this particular non-consolidation decision. However, the SEC is currently reviewing The Bancorp’s financials for the years 2010-4 in conjunction with the bank’s handling of mark-to-market accounting of the now discontinued commercial loan portfolio.

The Bancorp case is important for two reasons, one general and one specific:

First, banks are highly leveraged entities (low capital / asset ratios) subject to strict mark-to-market accounting principles for their loan and asset portfolios. In response to the subprime mortgage meltdown a decade ago, the US Congress passed the Dodd-Frank Act of 2009-2010 which, among other things, required FDIC-insured banks to maintain a Tier 1 leverage ratio (capital / average assets) greater that 5%.

This means that a relatively small (e.g. 5%-10%) mark down of a major asset class — whether it be loans outright or collateralized debt obligations — could wipe out a third or more of a bank’s capital. This would almost always cause a bank to fall below the Dodd-Frank standard for a “well-capitalized bank”.

Falling below the Dodd-Frank standard would trigger an existential crisis for any bank, forcing a merger or a private placement, often coupled with a massive shake-up of management and the board.

Because of Dodd-Frank, the temptation is greater than ever for a bank to offload troubled assets not fully marked to market to a non-consolidated VIE.

Second, The Bancorp in particular has a two and a half years running history of erratic mark-to-market accounting of troubled loans, followed by a series of moves to avoid falling below the Dodd-Frank standard.

In August, 2016, The Bancorp reversed a downward spiral toward the Dodd-Frank standard by securing an additional $74 Million in capital from two new investors with terms and conditions suggesting that the bank was desperate to get a deal done.

Finally, The Bancorp case study has an interesting human interest angle as there is a single mastermind behind the dealings and questionable accounting. For Enron, it was CFO Jeffrey Fastow, “the smartest guy in the room”, who began his career at a big bank in the 1980s working in the nascent market for CDOs.

The Bancorp’s “smartest guy in the room” with a history of testing the limits of GAAP is its long-standing Chairman of the Board, Daniel G. Cohen. The Bancorp was founded by his mother, the legendary Betsy Z. Cohen, but it is her son that controls the bank.

A majority of the bank’s Board has worked directly for Cohen or served on Boards of financial intermediaries he has created over the years. This includes 6 of the 9 bank Board Members — Chairman Daniel Cohen along with Beach, Bradley, Kozlov, Lamb, and McEntee III.

In researching articles we have written about The Bancorp, we discovered that Cohen has been the CEO of a number of companies that create and trade CDOs, most of which imploded in the financial crisis of 2008-10.

The Bancorp Case

In its 3Q14 10-K, The Bancorp announced that it was discontinuing its $1.2 Billion commercial lending operation. It set aside this portfolio on its balance sheet, claimed it was marked-to-market, and that the bank was actively seeking buyers. Since that announcement, the bank has had considerable trouble selling off the most troubled segments to third-parties.

As we have said in earlier papers, “fairly marked assets sell fairly quickly”. A corollary is that failure to sell fairly marked assets is an indicator that the assets are not marked-to-market.

On the next to the last trading day of 2014 when most of us are making New Year’s plans, The Bancorp issued a terse 8-K saying it had made the first sale to a partnership called Walnut Street 2014-1 Issuer, LLC.

Nine months later when it finally issued its 2014 10-K (another bank debacle detailed by us elsewhere), the bank revealed that it did not consolidate this LLC into its balance sheet despite the fact that the overwhelming proportion of the LLC’s financing came from the sale of notes back to The Bancorp itself.

What caught our eye initially in early 2015 was NOT the financing structure. That came out nine months later. What caught our eye initially was the stark contrast in markdown between the sale portion and the remaining portion of the discontinued loan portfolio. (see table below) (click to enlarge)

We speculated in an January 2015 article The Bancorp: Bad Moon Rising that the remaining portion might not be fully “marked to market” and fairly valued. Our speculation was validated 1 ½ years later in 2Q16 when the The Bancorp was forced by independent auditors to take an additional $32 Million in combined market-downs of the remaining portfolio on its books and write-offs of the notes received from the LLC to pay for the portfolio segment bought.

“(1) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance; and

(2) through its interests in the VIE, the obligation to absorb losses or the right to receive benefits from the VIE that could potentially be significant to the VIE.”

The table below is our presentation of the variable interests in the LLC as detailed in Note H of the bank’s 10-Ks: (click to enlarge)

The fact that bank waited until the day before New Year’s to disclose this sale in a terse 8-K plus the fact that the structure of the deal was so convoluted, giving its partner 51% of the voting stock despite practically no “skin in the game”, alone suggests right from beginning that The Bancorp is testing the limits of Post-Enron GAAP.

The Bancorp’s partner here is Angelo, Gordon & Co (AG & Co.) out of New York City. According to its website, AG & Co. is a large $26 Billion manager of “alternative investments” including commercial real estate mortgage-backed securities (CDOs).

Legally speaking, AG & Co. is an unrelated, third party to The Bancorp and its the Chairman Daniel G. Cohen. But, AG & Co. is listed as a “banner investor” of a firm that merged into Cohen’s latest concoction — a “blank check” IPO called Fintech Acquisition Corp, which we have written about in our paper Fintech Acquisition “Blank Check” IPO: Buzzy Name Fuzzy Aim.

The fact that AG & Co has practically no “skin in the game” plus the fact that its founders had prior dealings with Cohen suggest that the bank’s sale to the LLC was barely an arm’s length sale to an unrelated third-party.

In Note H of its 10-K, the bank at least acknowledges that it has the most exposure to LLC losses: “The Company’s maximum exposure to loss is equal to the balance of the Company’s loans, or $178.5 million.”

In terms of criteria (2) alone, the bank should have consolidated. But what about criteria (1) above?

In Note H of its 10-K,the bank has nothing to say about who has the most power to make decisions that affect the performance of the LLC. It just ends the note abruptly with this conclusion: “The company is not the primary beneficiary, as it does not have the controlling financial interest in WS 2014 (the LLC) and therefore does not consolidate.”

The purpose of the rest of the paper is provide evidence in support of our contention that it is high level executives at The Bancorp who make the key operating decisions that affect the LLCs financial performance and therefore The Bancorp should have consolidated.

Before we start, we just want to mention first that the very name for the LLC — Walnut Street 2014-1 Issuer, LLC. — marks its as The Bancorp’s venture, not some true partnership.

The Bancorp’s founder, Betsy Z. Cohen, the mother of Bancorp Chairman Daniel G. Cohen, was instrumental reviving the Walnut Street area of downtown Philadelphia in the 1970s by making risky loans to startup restaurants in the area. It is ironic that the same Walnut Street name that was associated with a civic-minded banker/mother in the 1970’s is now associated with a rule-bending banker/son now.

Officers and Directors

When trying to determine who controls the operations of an LLC, the usual place to start is a listing of the officers. Unfortunately, but not unexpectedly, Walnut Street LLC was formed in Delaware where such information is not publicly available.

Fortunately, we have found on-line a copy of the Purchase Agreement between The Bancorp and the LLC. It yielded two names associated with the LLC.

The LLC’s “Directing Holder” is Jonathan Lieberman, head of AG & Co’s considerable commercial and real estate loan trading operations. He is based in New York City. One has to wonder how much time Lieberman puts into an LLC where AG & Co.’s investment is mere $16 Million, or less than .5% of the Billions of real estate investments he must be managing.

The LLC’s “Designated Manager” is Kenneth L. Tepper, head of Kildare Financial Group, an independent contractor that has been used by the FDIC to sort bankruptcy messes. The initial address for the LLC was his office address in Gladwyne, PA.

It turns out Tepper has close ties to The Bancorp. According to a Bloomberg bio, Tepper has served as Managing Director of Financial Institutions Group at Cohen & Co, a firm founded by the family of Chairman Daniel G. Cohen.

Also, there is a 2012 article that says Tepper has worked on bankruptcy cases with Hersh Kozlov, a managing partner of the Philadelphia area law firm Duane Morris LLP. It turns out that Hersh Kozlov has been a Board Member of The Bancorp since 2014 and The Bancorp uses his law firm Duane Morris LLP.

In short, Kenneth L. Tepper was a front for The Bancorp when it set up the LLC in 2014.

Legal Activity

In trying to answer the question of who makes the key decisions that affect the LLCs financials, we start by asking what are the activities of this LLC that most significantly affects its performance?

The business of the LLC is managing an existing, troubled commercial loan portfolio already marked down 28% from principal. There is no need for loan officers to drum of new business, get appraisals, or to create new loan documents.

There is a need for servicing existing loans — posting remittances, checking certificates of insurance, sending out routine delinquency notices. etc. The Bancorp discloses in Note H of its 10-Ks that it has a contract to service the LLC’s loans. But, servicing existing loans does not have material impact on financial performance.

The really important decisions of the LLC involve the handling of delinquent accounts. This involves face-to-face meeting with borrowers who are mostly in the Philadelphia area. It involves facilitating refinancing with other banks. It involves directing lawyers to file documents in area courts to recover from borrowers who have defaulted on their loans.

Here is an a quantitative estimate of how many loans are involved in the LLC portfolio. The Bancorp’s CFO Paul Frenkiel gave some detail in a 2Q16 conference call regarding the concentration ratio in the discontinued operations portfolio. By applying the same ratios to the LLC loan portfolio, (see below) we can get some idea of the number of large loans in the LLC portfolio: (click to enlarge)

The core of the LLC activity is working with approximately 29 total customers, concentrating on about 5 customers with outstanding loans principals averaging $20 Million. Losing one to default would be impactful. Losing two would be disastrous.

Below are links to two 2016 filings by lawyers on behalf of the LLC to recover from borrowers who have defaulted. The total claims amount to $28.2 Million, or 14.6% of the total loan portfolio. In both cases, the lawyers are based in the Philadelphia area and have close ties to The Bancorp.

In June 2016, a suburban Philadelphia paper reported a sheriff’s sale of a suburban shopping center where the owners were in default of loans held by the LLC.“According to a schedule of the Schuylkill County Sheriff’s Sale of Real Estate, the mall has been listed for sale based on a judgment of $27,428,876.” This single default represented 13% of the LLC’s total portfolio.

The article mentioned that the LLC’s claim for damages was filed by Dana B. Klinges.

It turn out that Klinges is with the law firm Duane & Morris LLP. where Hersh Kozlov, a Board Member of The Bancorp’s is a managing partner.

While we have evidence that all of these outside lawyers have close ties to The Bancorp, we have no hard evidence as who specifically gives them high-level direction. Who do these lawyers discuss strategy with in face-to-face meetings in the Philadelphia area? Who reviews their invoices? Who signs their checks?

Based on court documents in connection with the shopping center case cited above, The Bancorp executive that lawyers report to is Daniel Sacho, current Executive Vice President of Commercial Lending and Real Estate.

The Bancorp’s Headquarters is in Wilmington, Delaware. The Bancorp maintains a large office at 1818 Market Street, 28th Floor in downtown Philadelphia. Of note, several other companies controlled by Daniel G. Cohen — Rait Financial Trust and Cohen Bros. & Company — also maintain offices on the same 28th floor.

A high level bank executive based in Wilmington at The Bancorp’s HQ is only 37 miles and a 40 minute ride by train or car away from their downtown Philadelphia office.

Finally, here is an example of anassignment document transferring a loan from The Bancorp to the LLC. The address used for the LLC was ℅ The Bancorp Bank, 712 Fifth Avenue 8th Floor, New York, NY 10019. This is the same address used by Chairman Daniel G. Cohen for his Fintech Acquisition Corporation.

Accounting Activity

By selling a segment of its discontinued operation’s loan portfolio to an unconsolidated LLC, The Bancorp escaped rigorous, transparent, and periodic examination of mark-to-market GAAP for its troubled commercial loans.

But, those troubled loans were largely replaced on the bank’s balance sheet by $193.6 Million in notes issued by the LLC. The Bancorp has chosen to label these notes an “investment in unconsolidated entity.” While not subject to the same rigorous and periodic examination as direct loans, nevertheless this investment is subject to review as to value.

Normally, mark-to-market accounting of loan portfolios and investments are reviewed by a bank’s independent auditor, in this case, Grant Thornton LLP.

However, on July 28, 2016 in its 2Q16 conference call, The Bancorp disclosed that it had engaged several independent auditors to review both the on-balance sheet portfolio and the off-balance sheet portfolio of the LLC. Per their recommendation, the bank took a total of $32 Million in combined mark-downs of its on-balance sheet portfolio and write-off of its on-balance sheet investment in the LLC.

This surprised Wall Street and sent the bank’s stock down for a 14% one-day loss. This was the first time The Bancorp’s financials took a hit from its commercial loan operations since it declared it a discontinued operation nearly 2 years ago.

The bank must have known ahead of time that this disclosure would would cause investors to worry about how close the bank was to the Dodd-Frank standard. Two weeks later, on Monday August 8, 2016, The Bancorp announced a private placement of combined common and convertible preferred stock for a total gross consideration of $74 Million.

The Bancorp’s 2Q16 conference call revealed how deeply it was involved in its non-consolidated LLC. Here is an exchange revealing that The Bancorp had hired independent auditors for both portfolios and that, in particular, it had hired one independent auditor to work on both:

William Wallace (Analyst, Raymond James & Assoc.)

Okay. And do you have the same person or firm or company that’s valuing the value of those loans versus the ones that are in your discontinued ops.

Paul Frenkiel (CFO, The Bancorp)

We actually use multiple companies, but our primary loan review company, we have one loan review company for discontinued ops and we have another one that also does work on that, but it is more specific to the one that’s [doing] the investment in that [un]consolidated entity.

Conclusion

Investors eventually sense when a publicly-held company pushes GAAP to the limit. It’s stock price begins to fall long before any outside auditor or the SEC steps in to question its accounting publicly.

The stock market has already punished The Bancorp for its handling of mark-to-market accounting and its painfully slow disposition of its discontinued commercial loan operations. Between March, 2014 when it first announced an unexpected additional mark-down of its loan portfolio and June 12, 2016, the stock has fallen 69.3% from $19.98 a share to $6.12 a share.

Even though The Bancorp has moved a segment of its troubled loans off its balance sheet, its balance sheet eventually took a hit anyway. Pressure from investors eventually forced the bank to accept an independent auditor’s recommendation to write-off a portion of the notes it took back from the LLC.

The problem is “eventually” is not good enough.

In July, 2016, The Bancorp announced that it had settled a class action suit brought by investors who had lost $100+ Million during the past two year. The settlement was for a paltry $17. 5 Million, of which the bank said that 100% was covered by insurance.

The Bancorp’s outside auditor Grant Thornton LLC needs to force the bank to explain in greater detail in its Note H why it believes it is in compliance with both criteria specified in FASB 46R – Statement 167. The SEC, FDIC, and the Federal Reserve need to review this case of non-consolidation.

Allowing The Bancorp to get away with this non-consolidation sends a signal to banks that they can avoid falling below the Dodd-Frank standard by setting up blatantly convoluted VIE’s similar to Walnut Street 2014-1.